The question of whether fiscal policy should be pro- or countercyclical has become increasingly relevant during the recession. This column provides causal evidence from South American countries showing the success of countercyclical policy in improving social indicators of economic success, combined with correlative evidence from Europe. This represents a strike against the case for austerity-led growth.

Fiscal policy in many developing countries is typically procyclical. Expansionary in good times and contractionary in bad times, these policies often amplify business cycles. The most convincing explanations for such practices seem to be limited access to international credit markets during bad times and political pressures that tend to encourage too much public spending during boom periods (Calderon and Schmidt-Hebbel 2008). Whatever the reason, the pattern is well documented (see Frankel, Vegh, and Vuletin 2011 on the spending side and Vegh and Vuletin 2013a on the tax side). In particular, contractionary fiscal policy in bad times seems to have increased the severity and duration of crises (Vegh and Vuletin 2013b).

Ironically, the procyclicality of fiscal policy has also become a hotly debated issue in the context of the current crises in Europe, with influential economists such as Olivier Blanchard (IMF Chief Economist) arguing that fiscal multipliers in the Eurozone have been underestimated by the IMF and others and thus that the contractionary effects of fiscal austerity have been considerably higher than typically believed (Blanchard and Leigh 2013).

Counting the social impact

Lost in much of the discussion on fiscal-policy procyclicality has been the social impact of contractionary fiscal policy during recessions – things such as:

the poverty rate,

income inequality,

the unemployment rate, and

domestic conflict.

In a recent research paper we look at how the fiscal-policy responses to GDP crises have affected social indicators such as those listed above (Vegh and Vuletin 2014). We find that contractionary fiscal policy during crises has tended to worsen social indicators both in Latin America and, more recently, in the Eurozone, which calls into question recent claims on ‘expansionary fiscal austerity.’

Crises and fiscal-policy responses in Latin America

For this study, our sample of Latin American countries is comprised what is commonly referred to as LAC-7 (Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela) and Uruguay. The combined GDP of these eight economies account for more than 90% of the region’s GDP. Due mainly to our need for quarterly data, the sample period for each country differs but, with the exception of Venezuela, all samples start in 1980 or earlier.
Analyzing policy responses to ‘crises’ naturally requires defining a ‘crisis.’ For simplicity, we focus exclusively on the behavior of real GDP and define a crisis as beginning in the quarter in which real GDP falls below the preceding four-quarter moving average and ending in the quarter in which real GDP reaches the pre-crisis level.

Using this definition we identify 34 crises in our eight Latin American countries (see Table 1).

Table 1. GDP crises: Basic stylised facts

Argentina spends the most time in crisis (number of quarters in crisis over total number of quarters) and Colombia the least.

The average duration of crises is 11 quarters and the average intensity of crises (measured as the fall in the level of GDP from the start of the crisis to the trough) is 8.6%.

If we break our sample into the periods before and after 1998, how have the frequency, duration, and intensity of crises in Latin America changed? 1

Figure 1, Panel A shows that on average, GDP crises have become less frequent in the post-1998 period and even less so in the most recent period covering the global financial crisis. The average duration and intensity of crises in Latin American has also fallen in the post-1998 period (Figure 1, Panel B).

We argue that the lower frequency of crises may be simply due to ‘luck;’ Latin American crises are mainly explained by external factors (commodity prices, global liquidity, etc.). The reduction in the severity and duration of crises, we argue, is explained by a shift, on average, from procyclical to countercyclical policy choices.2 In other words, we find significant statistical evidence showing that more countercyclical fiscal/monetary policy leads to shorter and less severe GDP crises.

Behavior of social indicators

Figure 2 looks at the behavior of four social indicators (poverty rate, ratio of richest 10% to poorest 10%, unemployment rate, and domestic conflict) during the GDP crises episodes identified in Table 1.

Panel A shows that, on average, the poverty rate has increased much less during GDP crises in the post-1998 period than before.

In fact, it barely changed during the global financial crisis. The same is essentially true of the ratio of the richest 10% to the poorest 10% (with the ratio actually falling during the global financial crisis).

Panel B shows a similar story for the unemployment rate and domestic conflict.

In the post-1998 period, the unemployment rate has gone up by two percentage points, compared to 3.6 percentage points before 1998. Since the global financial crisis, it has increased by even less. Domestic conflict has also risen by less in the post-1998 period and has actually fallen since the global financial crisis.

In short, social indicators during crises in Latin America look better after 1998. The question then becomes whether we can relate this improved behavior in social indicators during crises to a change in the fiscal-policy response to crises.

The role of fiscal policy

We capture the cyclical stance of fiscal policy by looking at the correlation between the cyclical components of GDP and government spending. A positive (negative) correlation indicates procyclical (countercyclical) fiscal policy. Figure 3 shows scatter plots of the cyclicality of fiscal policy against each of the four social indicators. In each case, we see a positive and statistically significant relationship, which we interpret as saying that the more procyclical is fiscal policy, the worse is the performance in the corresponding indicator.

Figure 3. Latin America: Cyclicality of fiscal policy and changes in social indicators during GDP crises

Correlation and causality

Correlations do not imply causation. The business cycle itself, for instance, could lead to both better social indicators and more government spending. To look into this, we construct a ‘fiscal readiness index’ which is essentially an index of initial conditions that captures the ‘fiscal space’ that countries may have before a crisis to conduct countercyclical fiscal policy during the crisis. We then use this index to instrument for fiscal policy. With this, we find that causality runs from countercyclical fiscal policy to smaller deterioration in social indicators.

Eurozone: The old Latin America?

Do our findings for Latin America have relevance to the Eurozone Crisis? As of the last quarter of 2013, the GDP crisis is ongoing for six of the tencountries in our sample, with Ireland and Italy showing the longest crises.3 The average intensity of the current Eurozone crises is 8.3%, which roughly coincides with the average intensity of crises in Latin America (8.6% from Table 1). The GDP crisis has been the most intense in Greece (with a fall in GDP of 24% from peak to trough) and Ireland (with 10%).

How did fiscal policy react to the crisis? Figure 4 shows our measure of fiscal-policy cyclicality (i.e., the correlation between the cyclical components of government spending and real GDP during crises) for each of the ten countries.4

Figure 4. Eurozone: Country cyclicality of fiscal policy during last GDP crisis

Note: Domestic conflict is an index that comprises variables such as assassinations, strikes, guerrilla warfare, government crises, purges, riots, revolutions, and anti-government demonstrations.

The other six countries pursued countercyclical fiscal policy, with Germany leading the way.

In terms of social indicators, Figure 5, Panel A, shows the changes in the unemployment rate in our ten Eurozone countries. As expected, the biggest changes took place in Greece, Ireland, Italy, Portugal, and Spain. This is largely consistent with Panel B, which plots the changes in domestic conflict, with Greece and Spain clearly standing out.

Figure 5. Eurozone: Changes in social indicators during last GDP crisis

Note: Vertical axis is the correlation between the cyclical components of government spending and GDP (during last GDP crisis).

The question now arises: Has procyclical fiscal policy led to a more pronounced deterioration in social indicators during the crises? Figure 6 provides an answer to this question by plotting the index of fiscal cyclicality against the change in unemployment (Panel A) and the change in domestic conflict (Panel B). The relationship is positive and statistically significant. This is consistent with the idea that a procyclical fiscal response in the Eurozone has led to a more pronounced deterioration in social indicators.5

Figure 6. Eurozone: Cyclicality of fiscal policy and changes in social indicators during last GDP crisis

Policy conclusions

While many Latin American countries have ‘graduated’ from procyclical to countercyclical fiscal responses to GDP crises, many industrial economies (like Greece, Ireland, Italy, and Portugal) followed contractionary fiscal policies in the aftermath of the Global Crisis. Our work finds that countercyclical fiscal policies tend to soften the undesirable effects of GDP crises on social indicators such as poverty, income inequality, unemployment, and domestic conflict. On the other hand, austerity policies tend to worsen all of these social indicators.

This evidence supports the desirability of pursuing expansionary fiscal policies in times of distress – which may mean postponing for some time needed structural fiscal adjustment – rather than embarking on fiscal austerity in the midst of a recession.

Vegh, Carlos A and Guillermo Vuletin (2013b), “The road to redemption: Policy response to crises in Latin America”, paper presented at the IMF’s conference in honor of Stanley Fischer (November).

Vegh, Carlos A and Guillermo Vuletin (2014), “Social implications of fiscal policy responses to crises”, NBER Working Paper No. 19828. [A shorter version entitled “Fiscal policy responses during crises in Latin America and Europe: Implications for the G-20” is forthcoming in Kemal Derviş and Peter Drysdale (eds.), The G-20 at Five (Brookings Institution Press, 2014).]

1 While admittedly arbitrary, the choice of 1998 seems a natural one because (i) through formal regressions we can detect a shift in fiscal policy in the late 1990s; (ii) 1998 is a year without any crises and thus provides a clean break; and (iii) we needed to have a reasonably long window for the ‘after’ period.

2 We should note that this average behavior masks quite a bit of heterogeneity across countries, with Chile, Brazil, Colombia, Mexico, and Peru showing countercyclical fiscal and/or monetary policy responses to crises in the post-1998 period. Not coincidentally, these are countries that are often hailed in the financial press for having considerably improved their macroeconomic management over the years, with Chile being clearly the star of this ‘graduation’ movement (see Frankel 2012). At the other side of the spectrum, countries like Argentina, Venezuela, and, more surprisingly, Uruguay continue to be procyclical in the post-1998 period.